Public information and IPO underpricing

We analyze the effect of public information on rational investors’ incentives to reveal private information during the bookbuilding process and their demand for allocations in the IPO. Our model generates several new predictions. First, investors require more underpricing to truthfully reveal positive private information in bear markets than in bull markets (the incentive effect). Second, the fraction of positive private signals and of underpriced IPOs is increasing in market returns (the demand effect). Combined, these two effects can explain why IPO underpricing is positively related to pre-issue market returns, consistent with extant evidence. Using a sample of 5,000 U.S. IPOs from 1981-2008, we show that the empirical implications of the model are borne out in the data.

Introduction: Extant evidence shows that underpricing in initial public offerings (IPOs) is positively related to market-wide equity returns preceding the offering, suggesting that underwrit- ers fail to fully adjust oer prices for publicly available information. As pointed out by Loughran and Ritter (2002) and Lowry and Schwert (2004) among others, partial adjustment to prior market returns is puzzling since it implies that underwriters reward investors for easily available public information.

Author: Bakke Einar,Tore E. Leite,Karin S. Thorburn

Source: Norwegian School of Economics and Business Administration

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